- U.S. agencies change stance on banks holding CDOs
- Ownership interest a key factor to regulators
- Banks also hold $70 billion of CLO assets
The changes this week do not directly affect CLOs, and the fixes that are in view will not resolve longer-term problems facing CLOs as a result of Dodd-Frank financial reform. But the actions that federal agencies have taken are giving encouragement to advocates that answers can be found in the future to protect the viability of the asset class.
Instead, the immediate impact of the regulatory changes affects a related category of structured finance: collateralized debt obligations that are backed by trust preferred securities, or TruPS. The Securities and Exchange Commission, Commodity Futures Trading Commission and bank regulators said on Jan 14 that they would exempt those CDOs from divestment by banks that would otherwise be required under the Volcker Rule.
CDOs, which are backed by a variety of business and consumer loans, performed poorly during the Great Recession of 2007-2009, while CLOs, which comprise corporate loans, have generally held their value despite market conditions.
“There’s an irony here. These are portfolios that perform perfectly well. These are investment-grade assets. The Volcker Rule is supposed to prevent banks from holding risky, speculative assets,” said Meredith Coffey, executive vice president of research and analysis at the Loan Syndications and Trading Association, a New York based trade group. As the CLO rule stands today, “this interpretation would force a bank to sell a super safe, well-performing asset and take a loss on it, in order to comply with this idea of not investing in risky products. It’s exactly the opposite of what Volcker is supposed to do.”
Banks historically have not been not big investors in CLOs. Instead, they act as packagers and arrangers of CLO portfolios, which CLO managers then package and sell to fixed-rate investors, freeing up capital for the banks to make additional loans. Banks do, however, both issue and invest in TruPS because the instruments have attributes of both equity and debt investments. It was the packaging of these securities into CDOs that led to this week’s regulatory action.
Zions Bancorp, a $54.4 billion-asset regional bank based in Salt Lake City, announced in December that it faced a charge to earnings of $629 million, pre-tax, for putting its CDO portfolio up for sale as required by the Volcker Rule, rather than holding the assets to maturity. The American Bankers Association, a Washington, D.C.-based industry group, quickly took up the cause, suing the government over its TruPS rules. The pivotal issue was that the CDO terms included a change of control provision, authorizing CDO investors to dismiss or replace a fund manager under certain conditions, that constituted an “ownership interest” that would be prohibited under the Volcker Rule. The regulatory action exempted TruPS-backed CDOs from that provision under certain conditions.
In the case of banks such as Zions, the issue was urgent, because even though they would have until July 2015 to dispose of prohibited assets, they would first have to recognize the markdown for reporting purposes, said Elliot Ganz, the LSTA’s general counsel and executive vice president.
“Even though they have 18 months to deal with it in theory, it’s an immediate accounting issue,” Ganz said. And if community banks were forced to dump their holdings into the market, he added, “it creates a death spiral of price reductions.”
Lobbyists for the industry have asked the agencies to adopt the same principle for CLOs as they have for CDOs. While CDOs are discounted for balance-sheet purposes, U.S. banks do hold some $70 billion of CLOs, which are valued at par because of their safety and low impairment rate, Ganz said. A drop of 10 percent in the securities, which could result from a flood of supply hitting the market, could cost banks $7 billion of regulatory capital, he argued. “Here, any losses would be solely attributable to the Volcker Rule.”
Regulators have not given any indication when, or whether, they will extend the CDO exemption to CLOs, but even if the industry carries the day regarding the Volcker Rule, CLOs remain under threat from other provisions of Dodd-Frank. Chief among them, Coffey said, are risk retention rules that will require CLO managers to hold 5 percent of the funds themselves, which could chase all but the biggest managers from the market.
The LSTA has proposed a series of changes that could mitigate the problem, such as the establishment of a “qualified commercial loan,” similar to qualified residential mortgage under existing law, that would not be subject to risk retention rule or the acceptance of third-party investors. Its most recent proposal, in mid-January, was for the establishment of a “qualified CLO,” with a set of restrictions and protections for investors. Under the proposal, a manager would have to retain only 5 percent of the equity, not 5 percent of the notional value of the CLO’s debt tranches.
And other issues could yet arise, Coffey said.
“These are the issues we know about today. The problem is, the way the agencies interpret the rules, you could have a problem pop up down the road that the industry had not anticipated because there was no prior warning.”